It’s hard to discern what took place in a closed-door session at a remove, but some of the tidbits coming from last weekend’s Federal Reserve conference at Jackson Hole were worrisome. Note I didn’t have this sense about last year’s meetings, based on a reading of Jim Hamilton’s commentary (which may simply mean Hamilton was charitable, but I suspect not).

Nevertheless, even though I have only have some odd data points, they all seem to align. That could, of course, simply be due to too small a sample size.

The world’s top central bankers gather at their annual U.S. mountainside symposium today with a sense there’s not much more they can do to repair credit markets and rescue the global economy….

“All the central banks can provide now is time for the banking system to heal,” Myron Scholes, chairman of Rye Brook, New York-based Platinum Grove Asset Management LP and a Nobel laureate in economics, said…

The article quoted former Fed governor Lyle Gramley and former Fed researcher Brian Sack also resorting to that unbankerly word “heal”.

That might seem to be a useful recognition of the limited authority central bankers have. However, the Fed is increasingly in the hands of economists, many of them academics. “Heal” suggests the markets will somehow find a better equilibrium on their own. I wonder what evidence there is to support that view.

Perhaps more important in the US, the Fed is not just the central bank but also an important financial regulator, and the proposals advanced by Hank Paulson would greatly increase the Fed’s regulatory role. Yet the Fed has been almost completely unwilling to consider regulatory measures, despite early identification of failures on that front.

The big dead body in the room is the near-total breakdown of the private sector securitization process. The litany of failings is well known: lack of transparency; bad incentives; the central, problematic role of conflict-ridden rating agencies; frequent reliance on insurance (monoline guarantees or credit default swaps) that are now to costly and/or viewed with some skepticism.

The expedient, which has been the default modes through the entire credit crisis, was to have the Federal government assume the risk, in this case by expanding the role of government-affiliated mortgage issuers and guarantors. And while Ginnie and the GSEs went from accounting for roughly 40% of new mortgage issuance pre-crisis to 90% post, the debt markets began rebelling in February, pushing up agency spreads, and today there is considerable uncertainty as to what lies ahead Freddie and Fannie.

Now admittedly, Jackson Hole might not be the best format for figuring out whether and how to address the securization model. But as a central element of the problem, it merits real study, with input from people with relevant technical expertise. Is any such effort underway? From what I can tell, no.

Second, central banks appear to have gone from being concerned about the possibility of a systemic crisis to being concerned about inflation. Yet both risks are still live.

This was my third year attending the Kansas City Fed’s annual Jackson Hole Symposium. As always, I was honored to be invited and found the event, both the formal meetings and the informal discussions, to be engaging. But, quite frankly, I found this year’s confab to be the least intellectually satisfying of the three I’ve attended. Why? Policy makers, and even more so academics, just don’t seem to collectively “get it” when it comes to understanding what is unfolding in the capital markets right now, and the implication for a whole array of policies, not just monetary policy.

Now I don’t have any concrete evidence that McCulley’s specific beef with the Fed included its interest rate stance, but given Pimco’s rate cut cheerleading, it’s a likely guess.

But the fact that Pimco may be partisan doesn’t make McCulley wrong. The current situation, with strong inflationary and deflationary pressures (remember, the stagflationary 1970s did not have a deflation component) is out of bounds of modern experience, and likely any widely-used economic models. And the Fed and EU really are not the source of the inflationary pressures. China, and to a lesser degree other developing economies, have been the impetus behind rising energy costs (food is more complicated and more contested). As we have pointed out, monetary policies have considerable lags. Money supply growth in the US, UK, and EU is low to stagnant. Are central bankers acting like drunks under the lamp, applying the only remedies they have even though they aren’t a fit for the problem? Again, quite a few people to be trying to find solutions within established paradigms when we are way outside them. I don’t pretend to have an answer here, but I worry that not enough people are asking the right questions.

Third was this item from the Economist by Greg Ip, on a paper by Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, that got quite a lot of attention at the conference. Note it was also discussed in shorter form by Sudeep Reddy, Ip’s successor on the Fed beat at the Wall Street Journal, on its Economics Blog.

What is truly disconcerting and disheartening is the arguments made in the paper itself and its assumptions about regulations. From the Economist:

Reeling from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding. This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth, and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to raise capital requirements—at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained, and there would be less of a bust.

Yves here. With all due respect to Ip, this opener is more than a tad disingenuous. First, as reported in the Financial Times, banking regulators are being toughminded about having banks get their capital ratios up. Ip says that this move is self-directed when in fact it is externally imposed.

Since regulatory forbearance (letting banks have or use various equity fig leaves, and/or going easy on them with how their assets are valued) is the norm in past banking crises, I must imagine that regulators feel some external pressure, aka market demands, to be tougher on banks this time. John Dizard commented earlier that regulators had a plan that was a tad optimistic:

Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning…The US banks and dealers are through the first quarter, and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower….

It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters…

Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.

So the Fed’s undue optimism about the ease of raising funds may be one reason financial institutions are looking to shrink their balance sheets. But another may be much more straightforward: in the cold light of day, there aren’t as many good credits as there seemed to be at the peak of the lending frenzy. This line of though is consistent with the idea, discussed here before, that the economy is over-leveraged and debt levels need to go down. Thus deleveraging is necessary and salutary.

But that is not the premise of the paper, which assumes that any reduction in leverage must be a Bad Thing:

This sounds sensible. It may also be deeply flawed, according to a provocative new paper….Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system.

This sort of thinking is what got us into this mess. We have demonstrated that the losses of banks are socialized. They are wards of the state. Therefore, they are not entitled to high returns. There are plenty of parties that are keen for high return ventures, such as private equity firms. There is no reason for those to be undertaken by the banking system.

Regulated parties ALWAYS try to game the system. If that were a legitimate argument, we’d have no rules of any sort.

Back to Ip:

So what is the solution? The novel proposal of the authors, Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, is “capital insurance”: push banks to buy policies in normal times that deliver an infusion of fresh equity during crises. The proposal was the buzz among the assembled central bankers as they focused on how to deal with the next cycle.

The authors conclude that it is difficult to wean banks from leverage. Indeed, they question whether regulators should even try. Limited capital leads to good governance, they say. Supply bankers with too much equity and they will waste it on inefficient projects. Force them to rely on short-term debt, they say (rather overlooking evidence from the current crisis), and they will lend carefully lest wary investors yank their funds.

I’m glad to see the skeptical interjection from Ip. How does limited capital lead to good governance? Limited capital means higher leverage. That is tantamount to arguing that one will drive a car more carefully at 90 miles an hour than 45. One might be more focused mentally at 90, but one has much less ability to change course or slow down, and any accident is sure to be fatal.

To Ip again:

Moreover, higher capital requirements may not prevent banks from tightening the screws on the economy during downturns. In America banks are rapidly tightening lending conditions even though their “tier-one” capital—mostly shareholders’ equity—stood at 10.1% of risk-weighted assets as of June 30th, well above the 6% that regulators consider “well capitalised” (see left-hand chart, below). Bankers are not hoarding capital because they have hit their minimums, says Mario Draghi, governor of the Bank of Italy. Rather, they are worried that markets will punish banks where the capital buffers slip.

The answer here is pretty simple. Banks are delaying foreclosures, playing accounting games (even the supposedly conservative Wells Fargo has gone this route, stretching out its foreclosure process to present a more flattering picture). Bridgewater Associates estimates banks have taken only 1/5 of the losses they estimate they have already suffered. Banks have tightened up because they know where they really stand, and it isn’t pretty.

To Ip again:

Mr Draghi, like many regulators, argues that capital ratios should be tightened—perhaps mimicking Spain’s well-regarded system, where capital requirements rise during lending booms and fall during busts. But Messrs Kashyap, Rajan and Stein argue that since crises are rare, that will saddle banks with lots of wasted capital most of the time.

Bank crises are rare? Let’s see, S&L crisis, late 1980s-early 1990s, Japan bubble era end 1990-?, Asian-Russia-LTCM crisis 1997-1998, dot-bomb era (Greenspan was worried enough about deflation to run negative real interest rates for some time) 2001, and our current mess, 2007-?. I don’t consider three to five crises, depending on how you count them, in a mere twenty year period to be rare.

And again, we have this fictive disease of “too much capital” Who created this concept? Oh, I forget, two of the authors hail from the University of Chicago. As the Financial Times’ Martin Wolf noted:

Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.

This is a motherhood and apple pie statement, yet somehow that basic understanding has been turned on its head. You don’t run a system at the limits of its tolerance all of the time, or even most of the time. But the author deem that to be desirable behavior.

Now to the proposal:

…banks be made to choose between higher capital requirements and buying capital insurance. A pension or sovereign-wealth fund would earn a premium and in return deposit, say, $10 billion of treasuries in a lockbox. When a predefined point is met, the funds would be released to the bank….

This may be insurance in form, but not in substance. Insurance works for the provider either when he can write policies against well diversified pools (think auto or homeowners’ insurance) or customers value it enough that they are willing to pay for a pricey product (think travel insurance).

Here you have fairly undiversified risk. Advanced economies move together far more than they used to, thanks to globalization, and banks do to, thanks to international product syndications and wide-ranging operations among the top players. The FDIC had to be bailed out by Congress in the S&L crisis, and the signs are that it will need to be again (even though it is musing raising deposit premiums, it’s pretty clear than any increase sufficient to cover expected losses will be deemed to be kicking the banking system when it’s down).

That is a long-winded way of saying that realistically-priced insurance will be unattractive. So you either have a product that will be perceived to be too costly, or one that will be priced too cheaply, and will therefore fail in a crisis.

And there is another problem. We learned in the our current mess that all those fancy risk reduction techniques did not reduce systemic risk. Why? One reason (I think this was a musing by Timothy Geithner) is that per the driving metaphor, having better brakes meant everyone felt comfortable driving faster. There was no net improvement in safety from having (theoretically) better risk reduction tools.

Ip gives some caveats too:

Numerous questions dog the proposal, among them who would define the trigger point, where to set it, and what countries and types of firms (besides banks) should participate. Alan Blinder, of Princeton University, noted that crises hurt almost everyone. Unless an insurer can be found who benefits from a crisis, “the insurance premium is going to be extremely high, because you’re making people pay in times when they don’t want to pay.”http://www2.blogger.com/img/gl.link.gifAlso, although the present system has hardly been perfect, it is not necessarily broken. True, it has encouraged risk-taking and short-term borrowing, and banks have allocated their resources neither efficiently nor wisely. Yet, for all the pain, no large bank has yet failed—thanks in large part to the capital they had been forced to hold. And banks have raised a remarkable amount of new capital, equivalent to almost two-thirds of cumulative write-offs so far, although this is getting harder.

Of course, the crisis is far from over. The conference fretted that with the financial shock now a year old, the real economy may still have not felt its full effect. It may yet be too early to overhaul today’s capital arrangements. But change looks inevitable and even unconventional ideas are guaranteed a hearing.

What is scary is the subtext: this paper got a positive reception, and it appears to be due to a dearth of critical thinking and a deep-seated reluctance to regulate. This does not bode well for coming up with good long-term solutions to our financial plight.

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56 comments

Refering to Draghi and Italy. Well, the Italian banks are sweeping the foreclosure mess under the carpet by simply not foreclosing on people from what I hear.

But I would definitely worry that the Bank of Italy has quite simply no idea what its country’s banks derivative books look like as the Italease case showed. The central bank inspectors were going through its books in the months before it blew up and there’s no evidence they detected the problems.

Agreed the Italy example is debatable. There have been some pro-cyclical capital (i,e., make banks stock up on capital in good times, since they’ll tear through it in bad) ideas bandied about, notably by Charles Goodheart. They are pretty detailed to get around the objections that they are hard to implement. I had thought to mention them, but the post was already overlong.

One thing, frankly in my mind the biggest in their favor, is that they make it harder to form asset bubbles. They serve to take the punchbowl away when regulators lack the guts.

“Avoiding that through regulation — higher capital standards — may seem the natural response, but heavy regulation simply raises the incentive for getting around it.”

The idea that the incentives for getting around a regulation will greatly outweigh the cost to get around those regulations isn’t even an assumption, but something more like the walls of the framework.

The relationship between risk reduction techniques and systemic risk is even simpler than you make it out to be. I am not sure it is possible to reduce the total amount of risk on a global scale. It is very possible to slice the risk into its component parts and trade, give away, sell, or otherwise push the risk to other counterparties. The risk reduction strategies you speak of are risk reduction strategies to the original owner of risk. The risk still exists, and many people are well aware that this is one of the primary purposes of derivatives markets. However, whoever owns the risk in the end makes no difference to the amount of total risk.

In times of financial stress, what matters is the total amount of risk in the system. The owners of that are less important than the fact that the risk exists.

If you are a student of engineering, you will know that there are usually many factors that contribute to any single engineering disaster.

“Disasters providecompelling examples of what can go wrong if engineers (or others) are unethical. In addition, scholars such as Henry Petroski argue thatdisasters often stimulate progress in the profession – engineers learn more from failure than from successand so, though they ought toprevent disasters from occurring, ought paradoxically to embracethem once they have occurred.”

From wikipedia:

A system accident involves “the unanticipated interaction of multiple failures” in a complex system. This complexity can either be technological or organizational, and often is both. Such accidents are very hard to predict in advance, yet the problems which cause them are often blatant in hindsight.[1]

These accidents can resemble Rube Goldberg devices in the way that small errors of judgment, flaws in technology, and insignificant damages combine to form an emergent disaster. System accidents were defined in 1984 by Charles Perrow. James T. Reason extended Perrow’s work with human reliability[2] and the Swiss Cheese model, now widely accepted in aviation safety and healthcare.

Once an enterprise passes a certain point in size, with many employees, specialization, backup systems, double-checking, detailed manuals, and complex communication, employees recourse primarily to following rigid protocol, habit, and “being right.” And related phenomenon, such as groupthink, can also be occurring at the same time. Real-world accidents usually have multiple causes, and not just the single cause that could have prevented the accident at the very last minute.

What is called “safety” can be pursued in a rigid way, with the feeling that more than enough time and effort has already been spent on it and therefore with the social consequence that suggestions, of any sort, will be poorly received. Arguably, this was one of the contributing causes of the Space Shuttle Challenger disaster on January 28, 1986. In that situation, a group of engineers again became worried the solid rocket booster O-rings would malfunction in the low temperatures forecast for launch day (it was 39 degrees Fahrenheit at launch). They were ignored because NASA officials did not want to further delay the scheduled launch (already six days behind schedule) and did not want yet another complication (a very human motive), especially on a matter that had seemingly already been resolved. The managers seemed to take the view that the manager’s job is to “know the answer,” rather than to know how to find out, or how to coach their people to find the answer. In addition, the fact that something comes up yet again is itself information. In the best case scenario, this would have been part of a conversation that looked for both interim solutions and longer-term solutions. Challenger exploded 73 seconds after launch. The lives of all seven crew members were lost. The proximate cause was the O-rings malfunctioning in the cold weather.[3]

Often, processes and events are opaque (Perrow terms this ‘incomprehensibility'[1]) as opposed to transparent. When processes are ‘opaque’, it means that there is little genuine communication between the top of the chain of command and the people carrying out orders.

Organizations and technologies prone to system accidents can also be described as “clunky.”

Sorry to hijack this comments section, but I actually have some time today and this is a particularly juicy post.

The insurance that is spoken of in the articles and paper cannot work. Who is going to payout on this insurance when the crisis does hit? For the current crisis, what group of entities has the necessary capital to make good on this insurance? There isn’t all that many groups out there that can absorb this type of risk, and most of them are governments.

Also, Yves briefly mentioned the price of this insurance as being higher than than the potential insureds would want to pay. I am guessing that it wouldn’t be available at any price. There is also a problem in finding sellers of this insurance. This is due to the fact that the difference between losing $1M and $1B and $1T is not just a few orders of magnitude, but rather has a more profound impact on someone. There is an interesting thought experiment about flipping a coin and net worth. How much of a return on your net worth would you require to bet it on a coin flip? Well for me – it is a high premium, in the multiple of times of my net worth, but there is a number out there that would persuade me. But for Bill Gates, or as a better example, George Soros, there is no multiple that would suffice – they would never do it for any multiple. Who, or even what group, would be willing to pay a $1T payout?

With the payout sums involved, the insurance premiums would be close, if not even higher than the capital requirements as the model to price this amount of insurance isn’t even in the General Re range, but in the bring down federal governments range.

Additionally, the moral hazard involved in this insurance would be profound. We have paper after paper talking about how insurance for us small folks provides perverse incentives to drive faster and eat junk food. We have direct experience with what banks and other firms do when they have latitude to leverage up. they leverage up until they destroy themselves and anyone around them. The moral hazard risks of this insurance is of much farther reaching impact than any other insurance.

It is more than a little disturbing that these deep thinkers can’t see these fundamental issues. They are proposing insurance as a solution that no entity could afford to sell or buy.

The authors of this paper are fools. Perhaps clever, credentialed, cunningly intelligent and so forth. But still fools.

Look no farther than this:

“Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns.”

We’ve completely lost our bearings when ‘returns’ are calculated only at one moment in a fuller transaction. The ‘returns’ to the entire chain of securitization related to the unregulated, undercapitalized no doc, no income, no independently rated, fee-and-bonus driven incentives — and on and on — I say the ‘returns’ are atrocious.

But these fools want to perpetuate a banking market that rewards recklessness.

If so-called financial innovation is to be celebrated for distributing risk, then it ought to be held accountable for a ‘whole’ accounting of return.

Yves, I wanted to write about this same set of issues, with a different slant, because I have been a risk manager, and I think the writers of the paper were naive. Should I find time to write my piece, I would get to most of the way to your conclusions, but via a different path.

Underneath it all is a glaring contradiction: The Fed wants its cost of capital as cheap as possible, and in turn its patronage shared across the banking system. On the other hand capital market theory dictates that it in turn pulls the return spectrum down with it. The new paradigm of permamntely low rates and risk chopping leads to inexorably higher retiurns for everyone never mader a lot of sense. Why there should be continued confusion over why such a paradigm is unnatural seems to perplex only the utopians/academics. No surprise the pragmatic Pimco talsk its book for an agency bail and lower rates. Why even pay attension to them.

As it relates to insurers, you hit the nail on the head with the premium pricing. It is ironic that this debate is ongoing with the likes of MBIA, Ambac and even AIG self destructing for their inability to properly price risk. Why would they get it correct this time? Perhaps the real problem is that return expectations have been likewise unnaturally inflated (sort of the way the potential growth of the US economy has). Until those expectations come down the problem remains intractible. But th conundrum is that the US needs those returns to sell itself as the capital aven, otherwise yet another of our seemingly thinning comparitive “advanatges” lost. What’s left, really? Are we mortal after all? Naturally the question of protecting valuations at all cost is being played out daily in the equity market. The authorities, and I use that word loosely, see this as the front lines of the global capital flight, which may in turn have something to do with the dollar and confidence. If you are not going to march like Hannibal, and the economic return relative return incentive is diminishing, how then to attract capital? FDR during period of tinkering with going off the gold standard was fond of saying that the only thing that mattered to the currency was confidence. Well with the Chinese selling and the Russians selling (Agency) maybe we should not be surprised to see people reminded that the US is after all the only “true” safe haven..The discussion of the Central Bankers about time to heel and nothing further to do merely bolsters the idea that the US is left with very few options, and gunboat economics from this vanatege, as distasteful as it may be, seems a growing alternative…albeit with the same old problem, how to pay for it…

“Bridgewater Associates estimates banks have taken only 1/5 of the losses they estimate they have already suffered. Banks have tightened up because they know where they really stand, and it isn’t pretty.“

If Bridgewater is correct, then we’re just watching shares being shuffled around on the titanic and it is very clear that the most accurate factoid from the conference is their plan is to stall for time… hence all the deception, fraud, deliberate obfuscation. Anything to cloud transparency during the waiting game. A cynic could be excused for thinking they’re just leaving it all for the next guy.

I think “S” nailed it. Until I started reading the blogs (and this one is excellent) I could never understand how banks could make so much money when interest rates were so low (sure, they made more loans, but there are only so many people to lend to). Well, of course, its leverage (or, more truthfully, BORROWING).

The payout on the proposed insurance policy is not a normal insurance loss – it’s a late cycle capital injection.

I see no reference in the paper to pricing of the payout, but I’ve been assuming the capital is priced as a function of the market price of the stock when the payout is triggered, not completely dissimilar to the way a spot capital injection would be priced.

So it’s priced more like an at the money option than an in the money option when triggered.

If so, there’s no loss at the point of the payout. The risk lies in the subsequent stock price.

Whatever the shortcomings of the idea, there’s a difference in risk between insurance to cover credit losses and insurance to provide a capital injection.

A comparable risk might be what happened to the SWFs who pulled the trigger early on their stock purchases from Wall Street. But the macro triggering proposed in the paper is intended to consider this type of trigger timing risk as well.

In my opinion, too much is being made of feedback mechanisms to justify various reform proposals. How the system gets to its extreme is irrelevant. What matters is that the banks set enough aside one way or another to deal with it.

Its clear we agree that the mess can’t be insured. Now we are only debating on how to best deal with this uninsurable risk.

Rebel, I disagree with your proposed solution. We’ve gone through regimes of lack of regulation before and it ends the same in every case: a huge a prolonged crash of some sort, usually associated with a huge war.

In todays world, its not worth it. We need some regulation, some controls placed on the banks from the outside, or else nationalize them. I am tired every 15 years or so paying huge amounts of money to pay people who make much more money than me. The purpose of government is to attempt to control or mitigate uninsurable shared risks. If the behavior of a group threatens my way of life every 15 years or so, well the government should do something about it, or else I will get a new govt that can do that. I don’t really like paying people welfare, but realize its better than having to hire bodyguards. I don’t like having to pay a millionaire $2,500 so he can keep his lifestyle either when I have to bail him out every decade or so, and in this case, we don’t have to. All we have to do is slightly regulate the banks, and this problem goes away.

This regulation has a huge added benefit that we’ve only touched upon here: It guides capital allocation to more productive uses than trading. This alone is worth the additional regulation.

Regulation is useless unless the government is willing to prosecute the participants that break them. For what I’ve seen there has been and are violations all the time and I’m yet to see a banker being prosecuted (a la Enron).

Many years from now, when this era is explored with forensic microscopes, the core of this problem will come down to denial and an inability for central bankers, Fed-gurus and Treasury maniacs to realize that they are incompetent boobs.

This period will be a great data mining field for behavioral economics/finance:

The following is from a previous story, which IMHO relates to individuals in a micro sense, but clearly has Central Bank implications!

“Market investors’ relationships to their assets and shares are akin to love-hate relationships with our partners. Just as in a relationship where the future is unexpected, as the market fluctuates you have to be prepared to suffer uncertainty and anxiety and go through good times and bad times with your shares. You can adopt one of two frames of mind. In one, the depressive, individuals can be aware of their love and hate and gradually learn to trust and bear anxiety. In the other, the paranoid schizoid, the anxiety is not tolerated and has to be detached, so the object of love is idealised while its potential for disappointment is ‘split’ off and made unconscious.

“What happens in a bubble is that investors detach themselves from anxiety and lose touch with being cautious. More or less rationalised wishful thinking then allows them to take on much more risk than they actually realise, something about which they feel ashamed and persecuted, but rarely genuinely guilty, when a bubble bursts. Again, like falling in idealised love, at first you notice only the best qualities of your beloved, but when everything becomes real you become deflated and it is the flaws and problems that persecute you and which you blame.

i’ll make a more practical one: we already have evidence from the reinsurance industry that contingent capital solutions don’t work.

in the mid 1990’s, LaSalle Re (a reinsurance company sponsored by Aon) placed what I believe was the first ever “CataPut”. The security worked as follows. The proceeds from the offering were placed in an escrow account which held treasuries. The issuer then paid annual premiums into the escrow account. on a quarterly basis, the interest payments on the treasury bonds and the premiums were paid to the note holders. this provided them with a very high rate of interest (e.g., T+800) on their investment in the cataput.

If at the end of the term (5 yrs) there were no trigger event (as defined in the prospectus), the investors received their principal back. if, on the other hand, a trigger was tripped, the issuer could seize the proceeds (pro rata, depending on the level of losses) and use them to rebuild its capital base and/or pay claims.

the pitch to institutional investors was that they earned returns higher than that offered by high yield bonds with a default risk that was completely uncorrelated to the broader economy. the reinsurance company, on the other hand, had guaranteed access to non-dilutive equity capital in the event of a catastrophe.

the logic behind the cataput was compelling, but very few transactions ever closed. one problem was that institutional investors weren’t comfortable with unpredictability of losses. they are much more eager to “bet” on the direction of the economy or a specific industry’s business cycle, than they are to take a pure bet on the weather.

another problem (from a bond investor’s point of view) was that investors in contingent capital instruments do not have a claim on the assets of the firm in the event of a catastrophic event (e.g., in a credit crisis, subordinated debt has the potential to become equity). these claim rights clearly have value and may explain why the very same investors who are unwilling to invest in contingent capital notes are often willing to make subordinated debt and preferred equity investments in reinsurance companies (and other financial institutions) at lower interest rates. structurally, there isn’t much difference between contingent capital and subordinated debt, outside of the “control” potential of debt instruments.

anyway, the point of this long digression was to simply say that the reinsurance industry has already tried this. it didn’t work. i therefore doubt it will work with lender, where the issues of moral hazard and systemic risk are more acute.

Thanks for this thoughtful post. It is a refreshing break from the mindless and reflexive Fed-bashing engaged in by a blogosphere more interested in political correctness than objective accuracy.

With all due respect to the time and care you spent in composing it, I would like to mention a few points.

I think there is an issue of sample size here. It is not at all surprising to me that a University of Chicago paper addressing the crisis at its margins would be described by the WSJ as “well received”. I heard no other source describe it as well-received and given the demonstrably inferior quality of WSJ Fed reporting generally, this is anomaly is not at all a surprising outlier to me.

There were quite a few papers presented that were not even commented upon by the financial press. For example Mishkin’s paper was far more than merely trying to pump up the long end of the curve. It went to the core of trying to explore the RANGE of possible wealth effects from the collapse in housing prices. This was written by a Fed governor not directly opposed to the stance of the host of the conference (the Kansas City Fed, which selects the papers to be presented) and it is clear to me that it received just as much attention as this Chicago paper.

But the Wall Street Journal and the financial press in general ignored it. And there were numerous other papers (and rebuttals) presented as well.

All this being said, it is not at all easy to turn around the finances and destiny of a Banana Republic without cooperation from the fiscal and political authorities as well.

In these discussions, we need to continually be aware of our levels of description embedded in our policy prescriptions. Drawing on the work of Russell and Whitehead, the proposed regulatory framework must always be sufficiently broad in its jurisdiction to actually have a competent chance of success.

You ask if any attempt is being made to address the securitization model itself and you state your belief that this seems unlikely.

Given the globalized nature of the derivatives markets, it seems clear that TRANSNATIONAL structures need to be implemented to prevent the ubiquitous regulatory arbitrage being used to “game” any steps the Fed would take.

To that end, Corrigan’s chairmanship of the Financial Stability Forum fits this bill and is doing an excellent job. One of the critical aspects of the problem is that as of June last year TRILLIONS of these derivatives had never even settled. No person had any clue WHO owned them because of back office understaffing and other issues. So trying to allocate losses and predict economic outcomes from the derivatives catastrophe has been made much more difficult than it needed to be.

And the FSF, chaired by Geither’s predecessor Gerald Corrigan (current Managing Director of Goldman Sachs), has made outstanding progress in addressing this issue and in tackling other issues central to restructuring of the structured finance sector.

I must point out that my view of appropriate Federal Reserve policy is CLEARLY DIFFERENT than that of the FOMC, but I personally feel quite comfortable that I understand fully their rationale for their approach and it may well bear some fruit, although it would be helpful if Congress and President Cheney exhibited a shred of cooperation.

On that front, we know that Paul Volcker has endorsed Obama for president and plays a central role in his economic team. There is no better person in the world to smash the skulls of competing millionaires together until they become bloody enough to understand the importance of acknowledging other points of view. To some extent, I am sure there are some senior Fed officials who would very much look forward to Volcker as an interim secretary of the Treasury so that some of the necessary steps could be taken.

Some commentators have mistakenly characterized Jackson Hole as a “gabfest”. I would counter that it is much more than that. And the format of being a formal conference with papers presented and written responses formulated requires a time lag of at least 6 weeks.

And recall that 6 weeks BEFORE Jackson Hole, the consensus of the Federal Reserve was that they faced increasing tail risks of bad outcomes from BOTH directions of an unhinging of inflationary expectations AND an absolute crash and collapse in growth. So the papers presented to some extent reflected this consensus that, because events have moved so rapidly, has now clearly become outdated.

In my view, it is obvious that the NEXT decisive move in US interest rates will be downward. But if the Fed can wring out some of the inflationary expectations by talking tough in the meantime without crashing the market for agencies, more power to them.

Until this next move dramatically downward in the fed funds target (clearly before the middle of February in my view), they seem intent on ensuring that markets are orderly and that the necessary subsantial repricing is done in a context of diminishing bid/ask spreads, to the extent humanly possible.

The Fed can only do so much for this Banana Republic. It’s time for the fiscal and political side to step up to the plate as well.

I hadn’t heard of these products before, but I am not surprised they were not successful.

The points you bring up about these instruments not having claims on the firm and the unpredictability of returns are extremely important. I hadn’t thought of those points, but it raises a bunch of interesting issues. When putting up that much money, you do expect to ‘own’ something in return. These instruments don’t own anything but some cash flows. Then, at some random point, you could lose most of your capital, before anyone else.

I don’t like using the frame of incompetence in this case as it absolves the responsible parties the consequences of their stated intentions. While they are incompetent, they wanted to have a system where there was little to no oversight. The point that jesse makes about “plenty of regulations, just not enforced” has some truth – and the direct consequence of people in power making decisions to not enforce these rules in homage to their philosophy.

As a result, I don’t like to use incompetence as a framework to evaluate their actions.

the insurance is already in place: FDIC and btw- they are a “monoline”.

FDIC claims this year are going up and drying up the pool of available funds to cover all remaining FDIC banks.

What does the insurer do? They start charging higher premiums – ie they tell their member banks to fork over more cash to FDIC.

This also makes the ratios look awful and so no lending will occur.

I remember a very simple econ101 cartoon that explained the beginnings of banking.

1 man had a gold coin. He gave it to the farmer, who in a month, brought back the original gold coin and another for “interest”. The man now had 2 coins. He could loan to 2 more farmers who then brought back 2 coins each, giving the man 4 coins.

That’s banking.

Whats been going on since the dot.com bubble burst is a hunt for 1000% returns and even the banks got in on the act.

Now it seems, only Grandpa Paulson (who worked at Goldman Sachs) wants to apply some rules and regulations to the rowdy teenagers on a banking binge and the parents, in this case – the FED, won’t listen to Grandpa.

The rowdy teenagers just need time to “heal”.

Nobodywants to put their careers on the line so it will have to be an outside force that is faceless – ie the bond traders – who apply the rod to the spoiled children.

Agree with all your points on derivatives and CDS settlement etc. However, not clear on what the cooperation is that you allude too from fiscal side? The Fed is executing the Treasury strategy (strong dollar)? And what really can the federal gov do other than pursue more Keyenesian policies that don’t have much historical support (unless asset bubbles are counted). Further, and to your point, the Fed is try execute a controlled burn, but that is becasue the fiscal side simply can’t risk dollar / capital flight and a closing of their funding window. This has to be why the equity market has been essentially socialized. Maintain confidence at all cost. Maybe this Russia / Georgia situation is exactly what the doctor ordered ironically. A new cold war would certainly lend some credence to the dollar when the fundamnetals scream sell.

So the US is essentialy playing a waiting game hoping to take down the rest of the world which will create a window to keep rate differentials intact (or contract) as the rest of the world starts cutting. But the fiscal situation remains tenuous regardless. If as pimco suggests the US Gov runs Trillion dollar deficit (or close to it) and as you say the Fed is intent on bringing rates down further (while they print) are you not arguing that the FCB will essentialy take such a strategy lying down. You may be right but then again maybe not. Was not the Chinese call to Treasury suggesting that Agency debt must be backed not the ultimate tell?

Seems the solution is less about spending on infrastructue – although the newspapers will be filled with a new new deal and a new great society (maybe even a new GM, a green one) but more about retrenching much of the malignant economic policy that has resulted in accelerated rot over the past decade. That re engineering policy needs a lot more than Volker; it requires a realignment of expectations that will take at least a decade.

I previously asserted my belief that your position would benefit from an increased sample size.

I offer the following data points in the spirit of fraternity:

1. Bernanke was the first person I know of who inserted the meme “preventable foreclosures” into the policy debate many months ago. His dynamic speech on that subject helped spur the housing assistance legislation through Congress.

Although that legislation is clearly insufficient, it does contain a mechanism for dramatically strengthening its impact, which is important. Even Roubini regarded this legislation, on balance, as distinctly positive.

Bernanke’s identification of preventable foreclosures as THE accelerant on the deleveraging conflagration helped focus minds on how to right the ship.

As long as foreclosure rates are increasing, housing prices will continue to plummet and this poses the most urgent systemic risk we need to address.

2. The dramatic series of rate cuts from 5% to 2.5%, in face of harsh criticism from both the ECB and the jihadi Chicago boys looks in retrospect to have been a completely defensible move and the “sky is falling” arguments of the inflation hawks are now receding dramatically. Those cuts have most likely decreased the speed of our crash and allowed the markets and ourselves to prepare for a more gradual descent into downward mobility and banana republic status.

3. Bernanke has pushed HARD for increased regulatory authority, bringing Paulson largely on board for the need to do this. (Yves we differ here on how hard the Fed has pushed for this…)

4. Just as both Earl Warren and John Roberts increased the credibility of the Supreme Court by forging strong consensus and unanimity where possible, Bernanke has, after the asinine and impertinent conduct of the St. Louis Fed last October (plus or minus 30 days) is starting to produce FOMC minutes striking in their unified views. Even Fisher is clearly on board now. This increased institutional credibility is essential in times of crisis.

5. The Fed has clearly dispatched its governors throughout this catastrophe to various fora in a concerted effort to explain its actions and provide more transparency to its decisionmaking processes in a turbulent and highly uncertain regulatory environment.

6. The Fed has instituted a wide variety of measures to assist in liquidity to assist in orderly repricing of risk.

7. The Fed facilitated the rescue of Bear Stearns avoiding the complete collapse of the critical collapse of the tri-party repo market and all the consequences such an outcome would have had on the global financial system.

They did this at a POSSIBLE total cost to the taxpayer of 30 billion, an extraordinary bargain considering what would have been the costs to all of us of an immediate plunge into the dark ages.

This action, in defense of price stability, was lawful, according to many reputable securities lawyers, although that requires a broad and detailed discussion of precisely how. I save that for a future discussion.

I hope these additional data points assist you in steering your assessment of the Fed towards more favorable conclusions of their competence and dedication.

1. I googled “Bernanke” and “preventable foreclosures” and see a speech dated March 4, 2008. That is months after the Hope Now Alliance, had been implemented Plenty of others were on this theme before Bernanke. A useful turn of phrase does not put him ahead of the curve. And Hope Now was in turn in response to Congressional tooth-gnashing. Barney Frank has been particularly vocal.

2. As we have discussed here at length, rate cuts will not fix a solvency crisis. The only successful remedy to date to a massive debt overhang (aside from what the IMF imposed on the Asian Crisis nations, too painful for us) is Sweden, which I see invoked nowhere. The Japanese based on their experience, have publicly (a highly unusual move for them) told the US the solution lies not in rate cuts, but in recapitalizing the financial system, which is what the Swedes did.

3. Increased scope of authority is meaningless if one is unwilling to use it. Even the notoriously industry-friendly OCC was more aggressive in enforcing the Home Owners Equity Protection Act (it provided some protection to subprime mortgage borrowers). The Fed had to get yelled at by Congress this year before it started to admit that maybe it should have done more here. Similarly, the Fed has done nothing regarding looking into how to improve risk oversight, an area that it has abdicated to the industry. Various economists, including industry practitioners like Henry Kaufman, have made sound proposals here that have been completely ignored.

4. By some reports, the FOMC was badly split on this last vote, and many think the Fed’s credibility is nada due to its oversensitivity to the securities industry. Buiter is not alone on this; some well-placed investors and people with regulatory connections abroad have written saying the same thing, The public treatment of Bernanke is far more positive than the private views I am hearing.

5. The governors have often contradicted each other in speeches on inflation vs. rate cuts.

6. Those measures, as Buiter pointed out, almost seemed designed to maximize moral hazard. Caroline Baum has noted that the Fed would not have engaged in those rate cuts had it known it was going to implement the facilities. The fact that the crisis is not resolved and we appear to be on the way to having another year-end eruption, with each event requiring greater intervention, makes these facilities look like expedients. Yes, they may be needed to stabilize the patient on the battlefield, but what are you doing in the way of treatment beyond that?

7. The Fed could have lent Bear funds for 28 days as initially planned. That may have allowed for a rescue completely by private parties or with lesser Fed backup. Some have speculated that this was really a bailout of JP Morgan.

In re: Yves point #6, note that these remedies almost seem designed to extend the crisis into the next presidency. Ben is widely known as the expert on depressions and long term slowdowns. Why are the solutions he is implementing so ineffective in ending the problem?

for #7: Note that right now, JPM is effectively the acting clearing organization for the CDS market.

This is a partial reply to Yves re:recapitalization and to Ano re:PIMCO’s lower rate position.

Let’s hear it from Bill Gross himself:

“Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

To return the housing, cow milking, asset price deflating metaphor to its broader context, the increasing price of credit is a common denominator worldwide in the delevering process which it drives, or in turn, is driven by. If the cost of credit – the discount rate for present value – would go down, then asset prices would be better supported. Stocks wouldn’t sink so fast, commercial real estate wouldn’t wobble so, and Donald Trump wouldn’t have to exaggerate as often about how rich he is (make sure to buy T-Bills or GSE mortgages with that $95 million, Donald – if it closes). But the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list. For now, investors should remain in high quality assets – until – until, well…until the prospect for home prices points skyward or until the cows come home, whichever one’s first.”

In extreme simplicity its logic goes as follows: Our economy is about 70% consumption based; since wages have be stagnate for some time and the housing ATM is closed, declining consumption can only be altertered through housing price stabilization. A decisive floor in housing declines must be established, argues PIMCO, and lower rates are the path to such an objective.

I would have to disagree with Baum that the fed would not have engaged in the rate cuts. The rate cuts are an essential component of the bank recap plan via net interest margins (deposit rates). Look at the latest quarter across the bank balance sheets…it is a drop in deposit rates that drove much of the better than expected NIM expansion, which in turn helped beat the abused estimates.

Is Matt whatever is a real person or just a PR hack from the Fed. He is clearly tryng to establish the bonafides with the full name stamp etc.. Invoking the Warren court in a solvency crisis reaks of political hack.

Gross just doesn’t get it. Lower cost of capital helps his massive bond fund. This notion that lower capital cost raises asset values is a red herring. Gross himself points out that the value is the present value of discounted cash flows over the life of the asset. Why then if we know rate cuts are a transitory thing, would we discount the overall value of an asset by a stagnant rate. Doesn;t it seem more logical to match cash flows and rates over the life of the curve to arrive at fair value? Something like an OAS / monte carlo using rate paths methodology would likley show tat the lower cost of capital is more than offset by the out years blowback or the cost of the near term decisions. So the real point Gross is making is not whether prices go down but over what timeframe. Gross seems to think extending the time frame will help solve the problem. That is after all the Level III argument in drag.As Yves points out, he also doesn’t get (or doesn’t want to get) that this is a solvency issue. Gross also fails to mention or deliniate what the appropriate cost of credit is for healthy growth. Instead he reflexivily falls back on the cut rates and inflate prices. In short, he espouses the same thing Bernanke does, only his is out of pure self interest. This from the guy who was buying Wachovia in size at ~38 or so. Exactly what bulldozing a house has to do with the affordability nexus is a mystery. And Dean, as for hard to argue against, well not really. The argument against is that the consumption function in GDP is so distorted as to be now fully severed from reality. Therefore, the solution lies in not trying to support an equilibrium point that is unsustainable or recreate the psuedo wealth effect. The solution God forbid lies in lower consumption. Imagine that, no jet ski and Outback only once a week. Gross is the worst kind of shill, one that cloaks himself oin the populist garb/rhetoric. Then again his obligation is to his bond holders not you or anyone else.

I did overstate the point, and my dim recollection is Baum was not quite that aggressive either. Her point was more that the Fed has short-term rates lower than they’d like, had they known in advance they’d be creating these facilities, they would not have cut as deeply. They have little firepower left on the downside if some new cause for pause arises.

We already have securities in the markets that work exactly the way the authors want….They are called Hybrids…you can defer coupon on them (that is make them equity) at the time of individual company stress…The problem is or has been that the regulators allowed the financial institutions to count a lot of this as long term capital (without increasing the level of capital requirements themselves) and not as additional contingent capital that the authors suggest. The net result was that during boom times companies issued this form of capital to buy back true equity or not issue equity when they were expanding their balancesheet.

The problem is that no one will lend these scummy bastards money because they don’t thrust them.

The collapse of the banking system is a result of criminal fraud on the part of the banks and criminal negligence on the part of the Federal Reserve and government regulatory agencies under the republican administration.

Nothing can change that. In fact, the Fed is doing everything it can to promote the distrust.

“They may be needed to stabilize the patient on the battlefield, but what are you doing in the way of treatment beyond that?”

The most important first step in any crisis is to correctly identify the problem that must be solved. Although metaphors can be helpful guides in describing any problem, we must be careful that our metaphorical description bears some relationship in scope and severity to the issue at hand.

With that in mind, I think the comparison of the Fed’s role to treating a battlefield victim needs to be discarded on grounds it is unhelpful.

Here is why I believe this to be true.

Warren Buffett has properly described derivatives as the “weapons of mass destruction” of the financial system. His description was met with diffidence, boredom and snickering and is still not fully understood.

A more appropriate battlefield metaphor for the global credit meltdown is what should we do in the battlefield space after 25 nuclear weapons larger than Hiroshima’s 20-kiloton size have exploded, with several more direct one megaton (minimum) hits likely in the next 6 months.

Here are several “nuclear weapons” that have gone off in the financial arena within the last year that come to mind. Given a bit more time I could easily enlarge this list.

These nuclear explosions (Buffet’s WMDs of the financial system) include, but are not limited to:

The collapse of the monoline industry, the collapse of the Spanish housing market, the collapse of the British housing market, the collapse of the US housing market, the collapse of the Australian housing market, the country of Iceland flirting with default and bankruptcy, the run on Bear Stearns, the collapse of the term rate auction securities market, Fannie Mae going under water, Freddie Mac going under water, the collapse of the commercial paper market, the collapse of Carlyle Capital, the coming attack upon Iran with its effects upon the markets, the collapse of mortgage insurers, Europe plunging into a recession, Japan plunging into recession and several other nuclear weapons.

How should the local commander react to this battlespace with nuclear weapons going off everywhere when the Commander in Chief (President Bush) thinks the battle is going well?

This is the dilemma of the Fed.

In terms of seeking battle reinforcements to this GLOBAL catastrophe, Trichet and the ECB publicly derided the Fed for insisting this was a systemic threat, claiming Europe would be immune. The Bank of England thought that inflation remained a central concern. Award winning columnists such as Gillian Tett of the Financial Times expressed relief that the risk had been spread throughout the financial system, failing to recognize the formal similarities between the multiplicity of nuclear explosions and what happens in the final stages of a metastatic cancer. Because of the sustained nuclear attack that the developed world is undergoing, the Fed is completely incapable of going it alone.

Before we solve any crisis, we need to agree on the scope of the problem, as per any of the treatises on crisis management, Steven Fink’s pioneering work in the field being a prime example. This problem requires COORDINATED global intervention from central banks, political institutions and political leaders, far more than the Fed alone can provide.

You say that less consumption is the answer and I am not sure I disagree. Consuming today the goods of tomorrow is a short term tactic rather than a long term strategy and yet, my friend, this is precisely what we got (a short term tactic masked as an economy).

The question is how can one transition towards a lower consumption economy when in fact consumption is the name of one’s economy.

There is another more fundamental reason why less consumption and more savings is the answer. It is the reinvested savings that can recapitalize the economy. since most malinvestments will need to be abandoned and in most case have no rescue value.

This is our current dilemma: how can one recapitalize in the absence of savings. Are we going to ask some poor nation to support the habits of the wealthiest nation again?

“This problem requires COORDINATED global intervention from central banks, political institutions and political leaders, far more than the Fed alone can provide.”

It sounds reasonable but it is impractical. Central banks and politicians do not control global economies; they can only influence on the margins.

Our current global problem is one of synchronicity. All global markets, fueled by easy credit, went up at the same time and they all now coming down because credit restriction is a global reality.

Therefore, absence of balance is our key problem. With all economies, having greater inter dependencies than in the past, we have virtually ensured that we all experience boom and bust cycles at an approximate same time. The virtual certainty is the experience of higher highs and lower lows. I am sure we all agree for the moment that the higher higher will be a very distant topic. So, let’s get down to business: How low is low?

In extreme simplicity its logic goes as follows: Our economy is about 70% consumption based; since wages have be stagnate for some time and the housing ATM is closed, declining consumption can only be altertered through housing price stabilization. A decisive floor in housing declines must be established, argues PIMCO, and lower rates are the path to such an objective.

That’s patently absurd.

Since when are house prices the means that a country uses to support itself?

People support themselves with their wages and incomes – any constructive policy will target these.

This idea of using asset prices to support consumption is the source of all our problems, not the cure.

How can anyone suggest we need artificially inflated asset prices to rescue the economy when they’ve already caused so much misery?

Let's see….the crash of 1907 took the intervention of JP Morgan, whose financial resources were larger relative to the economy than that of the Federal Reserve today. The US did not begin to recover from the Great Depression until deposit insurance and the Home Owners Loan Corporation were in place (1033) AND the Fed reflated in 1934. The crippling stagflation of that late 1970s was tamed only via aggressive, painful Fed intervention in the early 1980s. The comparatively speedy recovery from the S&L crisis is widely credited to the formation of the Resolution Trust Corporation.

I would say that the central banks and sovereigns have more influence than merely being “at the margins”, although clearly their influence lessens every year.

And clearly they have more influence united than they do divided, with Trichet and the BofE snickering on the sidelines, fighting the battles of November 1923 all over again.

Of all the nuclear weapons I listed going off (weapons of mass destruction) in the financial sector, one clear thread connects the vast majority of them whether they be the monolines, FRE, FNM, auction rate securities, Bear Stearns, Carlyle Capital, the collapse of the commercial paper market, the collapse of the Spanish housing market, etc., they ALL contain a common thread….

HYPERLEVERAGE.

As Buitter and Bernanke have both pointed out, HYPERLEVERAGING is a critical concept to understanding the creation of asset bubbles.

Keep in mind that in the 1920s you could purchase stock in the US on 5% margin. That HYPERLEVERAGE contributed substantially to the crash of 1929.

After Glass-Steagall raised the margin requirements to 50%, the stock market behaved much better in the following 75 years.

But the bond markets and derivatives markets are far larger than the bourses.

When you are HYPERLEVERAGED at 60 to 1 (as the GSEs are) the slightest mistake in your outlook is amplified enormously.

Globally, we need far higher margin requirements on these markets. That way there is greater margin for error.

And we won’t be able to place such enormous, leveraged bets on the futures of our grandchildren using failed valuation models that repeatedly fail to predict what are allegedly sigma 5 events, time after time after time after time.

Aformer US Treasury secretary, Andrew Mellon, once said the solution to the crash of 1929 was to liquidate labour, liquidate stocks, liquidate the farmers and liquidate real estate. He thought, as many do today, that the biggest danger to the economy was not what we now call de-leveraging, but inflation. For him, the only solution to the crisis was to let inflation drop. However, R.G. Hawtrey, formerly of the UK Treasury, argued in A Century of Bank Rate that a similar economic policy in Britain in 1930-31 – to focus on inflation – was the equivalent of crying “‘Fire! Fire!’ in Noah’s flood”.

This historical debate has resonance today. There is a rising chorus of protest at the unorthodox policy actions undertaken by central banks, especially the US Federal Reserve, and by more activist governments. How far is this protest justified?

The Fed has been criticised for the technical ways in which it has provided liquidity to markets, notably for lending to investment banks, which it does not supervise, on the same terms as it lends to commercial banks, which it does. The Fed has also been accused of acting, in effect, as a covert agent of the US government, by using its balance sheet to aid the takeover of Bear Stearns. However, in my view the Fed has been obliged to do unusual things to avert a systemic financial meltdown. I see nothingin its operations that is irreversible and cannot be undone as the sense of crisis evaporates.

The Fed has also been criticised on macroeconomic grounds. Critics, including in the Financial Times (“The Fed and the credit crunch”, editorial, August 26), say it pursued inappropriate interest rate policies and encouraged inflation. Others say it overstated the fallout for the wider economy from investment bank moves to deleverage balance sheets and reduce debt, and also overestimated the impact of falling house prices. The evidence does not support any of these allegations.

First, if the Fed had been pursuing policies so much more inflationary than the European Central Bank or the Bank of England, market-based expectations of US inflation should be higher. They are not. Expectations for inflation in 10 years in government-linked bond markets are for about 2.5 per cent in the US and eurozone, and 1 per cent higher in the UK.

Second, the focus of the credit crunch remains the US. Nine banks have failed already this year. This week the Federal Deposit Insurance Corporation said 117 banks and thrifts were considered to be in trouble in the second quarter, up from 90 in the previous quarter. The US financial system remains most at risk from further write-downs and losses in securitised products, including asset-backed securities and collateralised debt obligations. Credit problems will weigh on traditional forms of mortgages and other loans. As it becomes harder to raise capital, many banks are being forced into larger asset sales to shore up balance sheets. The self-reinforcing process of asset sales underscores why this downturn is different and why the Fed was right to try to moderate it.

Third, the erosion of consumers’ purchasing power from shrinking access to credit and dwindling housing wealth has only just begun. This is true in

the US and the UK. Consumers, unlike companies, tend to be slow to act. The Fed’s interest rate policy will be validated by the next two to three quarters of consumer spending and inflation data. The Bank of England and ECB’s policy rates will be seen as the ones that are out of line.

Fourth, the US Congress has already given tax rebates and passed legislation to help distressed homeowners. Government activism is essential in crises based on solvency issues that threaten a deep economic downturn. Much more should be expected. The two US government-sponsored housing agencies, Freddie Mac and Fannie Mae, will be re-nationalised, de facto if not in reality, quite soon. More fiscal stimulus focusing on public spending and infrastructure will emerge. Further legislation to manage the housing market is expected after the US election. The government may yet create agencies to buy mortgage-backed securities to unblock credit arteries, or to recapitalise institutions in need of help.

Doubtless these and other unusual policy responses in the US will be seen as inappropriate or inflationary. The response should be that unusual events merit unusual solutions, especially when systemic risk is present. As Hawtrey argued, “it is after depression and unemployment have subsided that inflation becomes dangerous”, if at all.

I have yet to see anyone comment on the fundamental source of our financial crisis, which is the constant manipulation of interest rates by the Fed and other central banks. Let’s go back to Econ 101 for a moment: the market price is where marginal supply meets marginal demand.

And what happens if the market is manipulated so that the price is below or above its natural level: shortages or surpluses, respectively. I wrote a pretty long piece about this recently.